Various economic theories have been proposed by different economic school of thoughts and they have explained the causes of inflation in different ways. According to the neo-classical economists, inflation is caused due to the increase in the supply of money. They believe that the economy functions at full employment. So, any rise in money supply leads to a proportional rise in price level.
On the other hand, Keynes explains that the inflation occurs when total expenditure exceeds total output/production. He stated that the increase in expenditure such as investment or government expenditure leads to increase in demand and hence causes inflation. Inflation is usually a non-monetary phenomena for Keynes.
According to the monetarist school of thoughts, inflation is a monetary phenomenon. Milton Freidman, one of the leading economists of monetarist school of thought states that even though rise in money supply leads to rise in price levels, the two do not have a proportional relationship.
Thus, incorporating the different school of thoughts, the modern theory of inflation considers monetary and real factors to explain he causes of inflation through demand pull and cost-push arguments.
Demand Pull Inflation
Inflation caused due to excessive demand is termed as demand pull inflation. It exists in the economy when overall price of goods and services increase due to increase in aggregate demand, but the aggregate supply remains the same.
When the economy is at full employment, it is not possible to produce goods and services any further because the available resources have been optimally utilized. In this case, the supply of commodities is limited, but the demand is increasing. Consequently, the price of the commodity rise and leads to inflation.
For instance, take an example of a kid who loves candies. Suppose he has two friends Ran and Tina. All the three kids want a particular toy available in the market with limited stock, maybe a single piece. All the three kids have 10 candies each. The kid loves candies, so in return for the toy, he is willing to give 5 of his candies. Ran, on the other hand, is willing to give 6 candies. However, Tina loves the toy more than she loves candies. So she is willing to give 8 candies.
In this case, the toy seller would set the price depending on the willingness of the customers to pay for the toy. If there are more number of people like Tina in the market, the shopkeeper will set the price high. The price of the commodities depend on the demand and types of consumers. As the demand is high, and stock of the commodity is limited, inflation occurs.
The example above defines how demand pulls price and leads to inflation in the economy. This can further be explained using the demand curve where the rise in price is caused due to the upward shift in demand curve.
In the diagram, the horizontal line shows quantity (AD & AS), whereas the vertical line shows price. As shown in the figure, aggregate demand (AD1) intersects aggregate supply (AS) at point A where, the equilibrium price level is P1 and the quantity is Q1. When the aggregate demand increases, the initial AD1 curve shifts rightwards to AD2 and AD3 which intersects the initial AS curve at point B and C in which the new equilibrium price level are P2 and P3 respectively.
The increase in price from P1 to P2 and P3 is known as semi inflation. The price rise from P1 to P2 and P3 is because of the rise in aggregate demand for goods and services at a given supply situation. Corresponding to the P3 level of price level, the economy has reached full employment level. So, the aggregate supply curve (AS) becomes vertical.
Further rise in AD to AD4 increases the price to P4 but there is no increase in output since, the economy is at full employment. Such increase in price is known as inflation. As shown in the diagram, the price continues to rise if the aggregate demand keeps increasing.
The gap that occurs when aggregate demand is more than aggregate supply at full employment level is known as inflationary gap. The concept of inflationary gap was first introduced by J.M. Keynes in his article ‘How to pay for the war’ in 1940.
According to Keynes, at full employment level, even when the demand for a commodity rises, the output remains the same. This causes a rise in price level and creates a gap between demand and supply of the commodity. The gap is termed as inflationary gap.
For example, the daily demand for milk in an economy is 1500 liters. But the economy can only produce (supply) 1000 liters of milk by utilizing its full capacity. This creates an excess demand of 500 liters, which is the inflationary gap.
Inflationary gap= Aggregate Demand – Aggregate Supply (at full employment level)
Diagrammatically, this concept can be better explained through the following graph:
In the figure, output (supply) is shown by X axis and aggregate demand is shown by Y axis. The line passing through origin is 45 degree line which shows aggregate demand is equal to total output. The AD curve (C + I + G) intersects the 450 line at point E. So, the point of equilibrium is E, and the equilibrium level of output is Y. Yf is the level of output at full employment level. At this level, aggregate demand YfA is greater than aggregate output (supply) YfB. So, the gap between aggregate demand and aggregate supply is AB which is known as the inflationary gap.
Causes of Demand Pull Inflation
Some of the factors contributing to demand pull inflation are explained below:
Increase in money supply
One of the most important reasons for demand pull inflation is the excess of money supply in comparison to output produced in the economy. When the central monetary authority of the country supplies more money, interest rates decline. This leads to more investment which further leads to increase in income through multiplier effect. Subsequently, demand increases, resulting in price rise.
Increase in government expenditure
Increase in government expenditure raises the income level of the people. Increase in income increases the expenditure (demand) of the households and shifts the demand curve upwards. But, at the given level of output, the growing needs of people cannot be met, which leads to an increase in general prices of commodities.
Increase in private expenditure
Total private expenditure has two components, consumption and investment. An increase in consumption directly leads to an upward shift in demand curve. Similarly, increased investment leads to more job opportunities and hence higher income level which also increases the aggregate demand. Consequently, the price level rises.
Reduction in taxes
Reduction in direct taxes lead to higher level of disposable income which increases the aggregate demand of households and individuals. At a fixed level of supply, a higher demand leads to inflation.
Increase in net exports
Increase in net export means more inflow of foreign currency which increases the income level of people. This leads to an increase in aggregate demand. But, at a given level of output, price levels rise as the demand is high but supply is limited. Similarly, more export and less import may result in shortage of commodities in the domestic market. As a result, demand increases but supply remains same, so prices rise.
When governmental expenses are in excess to its revenue, deficit of balance occurs. In order to level of deficit balance, government prints more money as a solution, which leads to inflation. Such situation occurs during war or internal conflicts.
Cost Push Inflation
Inflation caused due to an increase in the cost of production is known as cost push inflation. When manufacturing firms face higher production costs, they usually raise the price of their products to maintain their profit margins. This differential raise in price is cost push inflation.
Cost push inflation occurs when at a given demand level, aggregate supply declines due to increase in production costs such as labor wages or cost of raw materials. This causes the supply to decrease, consequently, increasing the price of commodities. Therefore, it is also known as supply side inflation.
For example, in 1970s, oil crisis caused a huge cost push inflation in the economy. The scarcity of oil due to Middle East-imposed embargo led to decrease in its supply. Since the demand remained same, the price increased rapidly causing the prices to inflate. Further, this inflated the price of other commodities which required oil as a raw material.
The concept of cost push inflation can be explained with the diagram below:
In the diagram, vertical axis represents price level and horizontal axis represents quantity level. At the beginning, aggregate demand curve (AD) intersects aggregate supply curve (AS) at point A, where the equilibrium price level and quantity are P1 and Q1 respectively. As the supply falls short and the supply curve shifts leftward from AS1 to AS2, the equilibrium level is restored at point B where the price is higher rises to P2.
If aggregate supply declines further, AS curve shifts to AS3 thereby causing a rise in price to P3. The rise in price levels from P1 to P2 and P3 is cost push inflation.
Thus, the figure shows that a decrease in aggregate supply of commodities in relation to demand leads to inflation, but at the same time reduces the output level in the economy.
Causes of Cost Push Inflation
The major factors leading to cost push inflation are described below:
Increase in wage rate
When the increase in wage rate is greater than the level of labor productivity, it leads to inflation. Although general rise in wage does not lead to inflation, the presence of labor unions, wages generally exceed productivity, thereby, causing inflation.
Increase in input prices or interest rates
The rise in prices of factors of input such as raw materials, electricity, water supply, oil, etc. leads to rise in price of goods and services. Similarly, increase in interest rates raise the cost of capital, ultimately leading to inflation.
Increase in profit margin
When manufacturing firms increase their profit margin per unit of output, with no increase in cost of production or demand of the commodity in the market, prices rise rapidly causing inflation.
Indirect taxation or removal of subsidies
Increase in indirect taxes like VAT, excise duty, custom duty, etc. directly increases prices of commodities. Likewise, removal of government subsidies also leads to higher payment of subsidized goods.
Depreciation of currency
If the domestic currency is devalued against foreign currency, the prices of imported goods increase. If the economy is predominated by imports, it will have greater impact on the domestic price movement, leading to higher inflation.
Factors such as natural calamities, power shortage, crop failures, strikes, etc. also cause shortage in the supply of goods and services, which leads to inflation in the economy.